Considerations for investing in the Spring of 2021

I have been putting this together over the last week or so, and I decided to publish after hearing about the Archegos Capital mishap, where Bill Hwang built huge leveraged positions in some stocks at multiple investment banks. When those stocks started to decline in value and Hwang couldn't meet his margin calls, it lead to a fire sale where basically all the banks tried to get out of their position at once, causing large losses for the banks involved. Overall, it was a large oversight on the banks risk management side of things. I bring up this story, because it is analogous to what my post is about, which is that risk has been building for years in stocks, bonds, and other investments and that many investors have overlooked this risk.  

This post isn't going to be about predicting the future, it is going to be my attempt to lay out where we are at currently. This is my assessment of the environment, but is ultimately an informed opinion backed by observation and it is open to debate. * 

The general overview is as follows. We are in an environment where stock values are at historic highs, interest rates at historic lows, and lots of debt is out there that wasn't underwritten with the greatest credit standards. This is a dangerous cocktail of risk. On top of these currents, there has been a general increase in investors appetite for risk building for years and less and less diligence has been used to make these risky investments. 

Valuations are at Historical Records for Stocks. 

Considering the Shiller Index(Measures the price of the S and P to the rolling 10 year average of earnings) at 35,  values for the S and P have only been higher at the height of the Dot Com bubble at 45, and were higher than Black Tuesday(The start of the great depression) at 30. There are other metrics that point to a historically very high valuations. One metric that sticks out to me is a statistic by investor Joel Greenblatt. There are over 300 publicly traded medium to large size companies that lost money(negative net income) in 2019(Pre Pandemic) that saw a 100% stock gain in 2020, whereas the median stock rose 70%. This is  quite the exuberance for unprofitable companies. 

Interest rates are at historically low rates** 

There has been a 40 year progressive decrease in interest rates, which has been a huge tail wind to bond prices and to stock prices as both prices generally will rise with decreasing rates**. Per Jim Grant of Grant's interest rate observer, real interest rates(actual interest rate - inflation) are at 4,000 year record lows. 

Low interest rates over the last ten years have caused a large increase in government and business debt and also led to poor credit/investment decisions***

     Risky business loans especially to Private Equity Industry(Where investors use a lot of debt to buy private companies to leverage their returns) have been growing for years and the credit quality has been deteriorating over the years. 

    Corporate Debt in general has been increasing for years with the low interest rate environment, leading to more and more leverage for many large publicly traded companies.

    Federal Debt has skyrocketed, and there may be a temptation by the Federal Reserve and Treasury to try to inflate their way out of it, long term. Also because debt is at such elevated levels federally, it will likely be more and more difficult for the Federal Government to borrow money to combat a financial crisis.

    There is reason to expect that Investments in Commercial Real Estate are at risk. Jim Chanos(A short investor who spotted the enron fraud) lays out a case that Commercial Real Estate could see a large decline in value and is in a very precarious place right now. The story basically is that Office and Retail Real Estate has been overbuilt since the Financial Crisis with easy credit and eager investors, demand for that space showed weakening even before Corona, the move from work from office to work from home and the move from in-store eating/retail to delivery is not temporary, and that these properties are financed at rates that leave very little room for error. The case begins at 1:01 on the podcast and is worth listening to in its entirety. For those more time pressed, Jim Chanos gives an example with numbers that really drives the case home at 1:09:25 where he breaks out how the finances of a office space can really change really quick. For those without much business/finance background I lay out the math and terminology you will need to understand the example at the very end of the footnotes.

A low return environment has led to a large increase in the appetite for risk 

    Even with the GFC(Great Financial Crisis) only 12 years removed, There is reason to believe that companies and individuals have been less and less diligent in understanding their investments over the last decade. Another way to say this is people are willing to take on more and more risk for less potential/reward. 

      Wirecard(A very popular German finance company guilty of fraud) could be part of a growing trend of companies that have questionable reporting. The questionable reporting isn't that concerning as that is always out there. What is more concerning is that this questionable reporting can be brought to investors attention via the press or short sellers and is more or less ignored. Murky Waters, a short investor, has done some good reporting on companies like this. Also in the Jim Chanos Podcast he talks about IBM being misleading on earnings. 

Many investors have been chasing growth perhaps at their peril. The large  premise seems to be technology could completely disrupt a market and a huge windfall could come to one company, and people will point to Amazon, Microsoft, and google as evidence of this phenomenon. My argument would be that people are overestimating the number of Amazons and Googles out there and also overpaying for a chance to own a company that could be the next Amazon. The argument comes down to this, the future is by definition uncertain, so there is no guarantee that a technology will completely disrupt a market. Even if it does, there is no guarantee that it will be done quickly, and finally there is no guarantee that the windfall/profits from a disruptive technology will come to only one company or even that the technology will be truly profitable(The airline industry historically was unprofitable for investors, despite being a world changing technology). The shining example of this is TESLA, who's market value is worth more than the top ten auto manufacturers combined and is selling at 1,000 times earnings and 20 times sales. For comparison Toyota is selling at  16 times earnings and 1 times sales. Sure there is a lot of things to be optimistic about, but perhaps many investors have been unwilling to consider the downside. 

Conclusion

I hope I have laid out the high level risks out there to consider with your own investment decisions. If I could draw some investment advice from this the article it would be this, "Considering all the risk out there, it is much more important to be focused on preserving your wealth as compared to growing your wealth." Or as some investors might say, "There are times to worry about the return on your capital, and times to worry about the return of your capital."

For some investors this might mean cashing out on some stocks in their portfolio, moving money from growth to value stocks, using stop losses to protect themselves in a down market or take money off the table in an up market, staying away from bonds,  investing in some gold(especially retirees who might want to protect themselves against inflation), having lots of cash available to buy cheap stocks and bonds in the times of a crisis, and/or  buying puts or other forms of financial insurance.  Its much easier and cheaper to do the work you need to do to protect yourself financially now in relatively calm markets, than it is to do this type of work in turbulent markets. 

Another point I want  make is it is important for investors to understand their investments, and if they don't understand their investments it might be worth putting their money into cash, gold, or an investment where they understand the risks and rewards. The obvious value of understanding your investments is that you minimize the chances of putting in over-valued or highly risky investments in your portfolio. But there is another value and that is if you understand your investments you can have conviction in your investments. This conviction is key, because without conviction chances are investors will sell good investments in a down turn because they don't have the conviction that the price drop is temporary. 

The final point is it might be worthwhile to consider the limitations of using diversification like buying ETFs, mutual funds, buying the S&P 500 to limit your risk. The reason is that since diversification reflects the overall market, if there is elevated risk in the overall market than it follows that there is elevated risk in the diversified investment(i.e. ETF, S and P 500, mutual fund, etc). Also because it is diversified it is harder to understand it, and hence have conviction in it. There might very well be reasons to own ETFs and the like to diversify your portfolio, but don't be lured into the trap that it is a sure fire way to limit your risk. 

FOOTNOTES

*This article is pretty bearish, and isn't providing a counter view on the bullish side. Though I am personally very bearish at this time, I invite you to consider other bullish points of view. Perhaps at some time I will provide some bullish counter points for people to consider. 

For my blog posts I will try to keep figures, examples and explanations as simple as possible to convey the thought process and the necessary concepts, and will generally follow the rule that it is better to be approximately right than precisely wrong when it comes to figures. 

**This phenomena is due to the large fact that stock and bonds' value is derived from the mathematical Formula called discounted cash flows(DCF) where cash you receive in the future is discounted to the present. The lower the discount rate(i.e. the interest rate + a certain percentage for risk) the higher the value of the investment and hence the higher the price. I think its fair to say that this tail wind for stock, bond, and other asset prices is going to stop, as people just won't loan out money at such low rates, where if you factor in inflation, they are actually losing money. 

*** These are footnotes on the increasing amount of debt and the decreasing quality of that debt

The two graphs below demonstrate the growth in risky debt, and the deteriorating credit quality of those risky loans. 

The graph below demonstrates the growth in business debt since the financial crisis. 

An explanation of how Commercial Real Estate is valued: 

Just a little backdrop on the math you will need to know to understand the example: Investment buildings are sold typically by a cap rate, which is a market rate that reflects the NOI(Net Operating Income i.e. Rents minus all operating expenses) as a percentage of the the property value, so if a property has a $1 M a year income and a value of $10 M, then you have a cap rate of 10%. The cap rate will change depending on the market environment and type of property and other factors. If you take the inverse of the cap rate, you get a multiple, the inverse of 5% is 20, the inverse of 10% is 10 and the inverse of 20% is 5, you then take that multiple times it by the NOI and you get the value of the property. For example a property that has a NOI of $1,000,000 and the Cap rate for that type of property is 5% the price is $20,000,000. With this as a backdrop I believe you'll be able to understand his example.